Is Your Stockpicker Lucky or Good?
Is it luck or skill? Picking a fund manager who can beat the index is tough, but picking one who beats it through actual ability is far more difficult.
Victor Haghani, a co-founder of one of the best-known investment firms in history, says the most surprising thing is that people have great confidence that they can pick these super-talented fund managers. Currently the chief executive of Elm Partners, which espouses index investing for wealthy clients, Mr. Haghani will try to prove that to you with a simple test.
He and two colleagues told several hundred acquaintances who worked in finance that they would flip two coins, one that was normal and the other that was weighted so it came up heads 60% of the time. They asked the people how many flips it would take them to figure out, with a 95% confidence level, which one was the 60% coin. Told to give a “quick guess,” nearly a third said fewer than 10 flips, while the median response was 40. The correct answer is 143.
Mr. Haghani’s belief in indexing means he has a vested interest in the outcome. His earlier experience as an active investor gives him perspective on how hard it is to beat the market. Mr. Haghani was a co-founder of Long Term Capital Management, the hedge fund that had spectacular results from exploiting real market anomalies before its failure nearly took down the global financial system in 1998.
The research applies directly to picking fund managers. We already know that most active managers fail to beat an index fund in any given year, yet many people pay up for managers they believe have the skill to do so.
For example, performance of the Fairholme Fund won its manager, Bruce Berkowitz, the distinction of domestic equity fund manager of the decade in 2010 from Morningstar. The fund had beaten its benchmark most years, and its compound annual return was an impressive 13 percentage points better than peers on an annualized basis.
The fund slumped spectacularly the very next year, lagging behind the S&P 500 by nearly 35 percentage points. The inevitable schadenfreude in the financial media elicited a rebuke from Mr. Berkowitz in his 2011 letter to shareholders. “One circling of the sun is too short a time to differentiate between good and lucky,” he wrote.
He was right, but perhaps not in the way that he meant. Writing in 2014, after two more years—one bad and one good—for Fairholme, Mark Hebner of Index Fund Advisors used statistics to determine if skill was responsible for Fairholme’s past success. Using a measure of how much Mr. Berkowitz’s fund tended to deviate from its benchmark and the same 95% confidence interval used in the coin-flipping paper, he concluded that it was too soon to tell. It would take 18 years to get an answer—longer than the fund had then been in business and far longer than most investors’ patience with a manager. For managers with more volatile results than Mr. Berkowitz’s, Mr. Hebner determined that it could take several hundred years of performance to discern the manager’s true ability.
There are other explanations for investing success that aren’t sustainable. Strategies such as value investing can fall in and out of favor. And, unlike loaded coins, an investment strategy that is a legitimate winner may not stay that way because others can try to mimic it. Long Term Capital Management produced spectacular results, but then its strategy was copied, and Mr. Haghani saw the erosion of their edge firsthand.
The confidence investors place in their ability to pick skilled managers is ultimately costly. Investors buy top-performing and top-rated funds without any ability to determine if skill or luck produced the gains. The result is that the typical investor in active funds lags behind even those funds’ return by quite a bit.
For example, when Mr. Berkowitz began his triumphant decade, his fund was tiny. By the end, it was large and then probably got a further boost from the award. During the year that it lagged behind the market by 35 percentage points, it took a lot more people’s savings down with it. For some successful funds, the effect is so stark that a fund manager retires with vast personal wealth and a wonderful reputation while never generating a net dollar of value for investors.
Coin flipping can get expensive.